Question

Suppose the marginal propensity to consume is 0.5. If the government believes aggregate demand is $500 billion below potential and any increase in government spending will experience $100 billion in crowding out, how much does the government need to increase spending to have aggregate demand reach potential?

Answer 1

The given aggregate demand is $500 billion below potential and any increase in government spending will experience $100 billion in crowding out,

It means gap is $500 and $100 will be crowded out if government increases its spending by any amount. It means the actual gap will be=500+100

=$600

MPC=0.5

MPS=1-MPC

=1-0.5

=0.5

Spending multiplier=1/MPS

=1/0.5

=2

The required government spending for filling this gap= gap/ spending multiplier

=$600 billion/2

=$300 billion.

Hence government need $300 billion to increase to have aggregate demand to reach potential level of output.